I am an analyst and anti-economic bubble activist who is currently warning about growing bubbles in Canada, Australia, Nordic countries, China, emerging markets, Web 2.0 startups, U.S. higher education, and more. I believe that the popping of these bubbles will cause the next financial crisis.

Here's Why The Stock Market Bubble Deniers Are Completely Wrong

As U.S. stocks rose to record levels in the past few months, a flurry of pundits have come out of the woodwork to claim – and deny – that stocks are experiencing another bubble.

I’ve also published a detailed report in which I laid out the case for why stocks are experiencing a bubble, though I believe that this bubble can continue expanding in the course of what I call the Bubblecovery or bubble-driven economic recovery before popping.

In this column, I will outline and debunk the most common arguments that are being used by high-profile U.S. stock bubble deniers, which includes former U.S. Federal Reserve chairman Alan Greenspan, Fed chair candidate Janet Yellen, Blackrock’s Russ Koesterich and Larry Fink, and Charles Schwab’s Liz Ann Sonders, to name just a few. Take note of the fact that these individuals have a vested interest in encouraging the public to risk their hard-earned money in stocks regardless of market conditions, and did not predict or warn about the global financial crisis, as I did. According to them, “it’s always the right time to buy stocks!” (similar to the argument used by Realtors ®), so please take their advice with a very large grain of salt.

Here are the most common, but logically unsound arguments being used to deny the fact that U.S. stocks are experiencing a bubble:

Argument #1: Stocks are the cheapest they have been in decades

This is by far the most common argument used to convince the public to buy into the latest stock bubble. While this argument is technically true, it is very misleading and a textbook example of lying with statistics. Most valuation measures indeed show that the U.S. stock market is near the bottom end of its valuation range of the past twenty years (according to the Shiller P/E ratio):

But if you take a longer perspective, not only are stocks not cheap, they are actually overvalued and at levels that marked the end of historic generational bull markets, and the start of generational bear markets (though some of these bear markets occurred in inflation-adjusted terms rather than nominal terms):

Other stock market valuation measures confirm the overvaluation reading that the Shiller P/E ratio is giving.

Here is the total stock market capitalization to GDP ratio, which Warren Buffett described as “probably the best single measure of where valuations stand at any given moment”:

Tobin’s Q Ratio (the ratio of the market’s price to replacement costs) shows the same pattern:

The last two decades have been an anomalous period of persistently high stock market and other investment valuations, so this period is not an appropriate reference point to use to determine if stocks are overvalued or not.

A related argument that many stock bubble deniers are making is comparing current stock market valuations to the extreme valuation reached at the peak of the Dot-com bubble in 2000. This argument is flawed because the 2000 valuation peak was such a glaring outlier that it is not a useful comparison gauge for determining whether the stock market is overvalued or not; the market can still be overvalued even if it far less overvalued than it was in the year 2000. Using the past century or so is a much more fair valuation reference as it includes the full range of the long-term valuation cycle, including generational valuation troughs – such as the early 1920s, 1940s, and the early 1980s – as well as periods of average stock market valuation.

Record low interest rates are the primary reason for the high stock market valuation of the past two decades. Interest rates set the tone for returns in other investments: high interest rates lead to low investment valuations (1982 is a great example), while low interest rates lead to high valuations.

I consider the past two decades of stock market overvaluation to be part of a longer-term “Bubble Era” that still has yet to end, and I believe it will eventually end when interest rates rise, which will result in a severe global economic crisis. As I wrote in my stock market bubble report, there are two primary scenarios I foresee that will lead to higher interest rates:

Scenario #1: After several more years of the Bubblecovery, The Federal Reserve has a “Mission Accomplished” moment and decides to end QE and eventually increase the Fed Funds rate, which pops the post-2009 bubbles that were created by stimulative monetary conditions in the first place. Rising interest rates are what ended the 2003-2007 Bubblecovery, which led to the Global Financial Crisis.

Scenario #2: The Fed loses control of longer-term interest rates after investors sell their Treasury bond holdings en masse in fear of a sharp decline in the U.S. dollar’s value after years of money printing.

Market bulls are making a mistake by assuming that stock market valuations can stay at such elevated levels forever; there will come a time when valuations revert to the mean and likely overshoot (as a result of a bear market), which will create the next generational valuation trough from which a new secular bull market can eventually rise from.

Unfortunately, the brief valuation plunge in 2009 was not the generational trough that many believe it to have been; generational valuation troughs often last for up to a decade, not just a few months, and the market’s valuation in early 2009 was still nearly double what it was in prior troughs.

Argument #2: The Bull Market Is Justified By Earnings Growth

As I explained in my stock market bubble report, I believe that U.S. corporate earnings are experiencing a bubble in their own right. Though some may scoff at the idea of an earnings bubble, that is exactly what occurred during the last bubble cycle from 2003-2007. Low interest rates fueled a bubble in housing and credit growth, which spurred a temporary U.S. corporate earnings boom in various bubble-related sectors, helping to boost the overall economy until the bubble popped. U.S. and global interest rates are even lower during this current cycle, and bubbles are inflating across the entire world.

While I won’t rehash all of my ideas from my report, here are some bullet points:

The global economic recovery is growing on the backs of post-2009 bubbles in China, emerging markets, Australia, Canada, Northern and Western European housing, U.S. housing, U.S. healthcare, U.S. higher education, global bonds, and tech (Web 2.0 and social media).

50 percent of the SP500’s earnings are generated overseas (up from 30 percent a decade ago), so U.S. corporate earnings are benefiting from temporary economic booms in countries that are making the same mistakes that the U.S. was in 2005.

Thanks to low interest rates, as well as rising housing and stock prices, financial sector profits have surpassed their peak reached during the prior bubble. The financial sector is on the verge of becoming the most-profitable U.S. industry once again, accounting for nearly 20 percent of the SP500’s earnings.

U.S. housing is experiencing an “echo bubble” or a Housing Bubble 2.0 and house flipping is making a comeback in former bubble markets such as Arizona, Nevada, Florida and California.

There is a growing automobile loan bubble and student loan bubble, which have been the two main drivers of consumer credit growth since the Great Recession. This chart shows how rapidly household credit is growing once again as deleveraging is officially over:

U.S. corporate profitability is at an all-time high, but record profit margins are never sustainable. Here’s the chart of U.S. corporate profitability:

The U.S. corporate earnings bubble will pop when interest rates eventually rise, revealing many sectors that have been experiencing bubbles and creating spurious jobs and earnings growth that would otherwise not have occurred without cheap credit conditions. It’s impossible to know the full extent of an economic bubble until interest rates rise and the bubble pops. Many areas that are booming today will be revealed to have been bubbles all along. To quote Warren Buffett, “Only when the tide goes out do you discover who’s been swimming naked.”

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.

Comments

Jesse, what in your opinion would differentiates a market which is just overvalued versus one that is in a bubble? Also, you mention the bubble may keep going for sometime, what tell tale signs will you be looking for at or near the peak?

Good question. I would say that there is a lot of overlap between the two concepts, so they are not mutually exclusive. Many people assume that a market can only be considered a bubble if it is rising parabolically (think Tulipomania or the Dot-com bubble), but my definition is broader than that as it includes unsustainable bull markets that are driven by cheap credit that will eventually bust and cause an economic crisis.

Thank you for a well-researched and intelligently written article! A little common sense helps also. On March 6, 2009, the S&P 500 touched an intraday low of 666.79. On December 31, 2013, the same index reached an intraday high of 1849.44. Throw in the dividends and stocks have basically tripled in less than five years. We know the U.S. economy hasn’t tripled since then or even doubled, so stocks must be overvalued and set to eventually drop by a lot. As my math teacher used to say, Q.E.D.